Derivatives Implementation Group

Statement 133 Implementation Issue No. B2

QUESTION

An investor purchases for $10,000,000 a structured note with a face amount of $10,000,000, a coupon of 8.9 percent, and a term of 10 years. The current market rate for 10-year debt is 7 percent given the single-A credit quality of the issuer. The terms of the structured note require that if the interest rate for single-A rated debt has increased to at least 10 percent at the end of 2 years, the coupon on the note is reduced to zero, and the investor must purchase from the issuer for $10,000,000 an additional note with a face amount of $10,000,000, a zero coupon, and a term of 3.5 years. How does the criterion in paragraph 13(a) apply to that structured note? Does the structured note contain an embedded derivative that must be accounted for separately?

RESPONSE

The structured note contains an embedded derivative that must be accounted for separately unless a fair value election is made pursuant to Statement 155. (Note that Statement 155 was issued in February 2006 and allows for a fair value election for hybrid financial instruments that otherwise would require bifurcation. Hybrid financial instruments that are elected to be accounted for in their entirety at fair value cannot be used as a hedging instrument in a Statement 133 hedging relationship.) The requirement that, if interest rates increase and the derivative is triggered, the investor must purchase the second $10,000,000 note for an amount in excess of its fair value (which is about $7,100,000 based on a 10 percent interest rate) generates a result that is economically equivalent to requiring the investor to make a cash payment to the issuer for the amount of the excess. As a result, the cash flows on the original structured note and the excess purchase price on the second note must be considered in concert. The cash inflows ($10,000,000 principal and $1,780,000 interest) that will be received by the investor on the original note must be reduced by the amount ($2,900,000) by which the purchase price of the second note is in excess of its fair value, resulting in a net cash inflow ($8,880,000) that is not substantially all of the investor’s initial net investment on the original note.

As described in paragraph 13(a) of Statement 133, an embedded derivative in which the underlying is an interest rate or interest rate index and a host contract that is a debt instrument are considered to be clearly and closely related unless the hybrid instrument can contractually be settled in such a way that the investor would not recover substantially all of its initial recorded investment. Paragraph 61(a)(1) clarifies that this test would be conducted by comparing the investor's undiscounted net cash inflows over the life of the instrument to the initial recorded investment in the hybrid instrument. As demonstrated by the scenario above, if a derivative requires an asset to be purchased for an amount that exceeds its fair value, the amount of the excess — and not the cash flows related to the purchased asset — must be considered when analyzing whether the hybrid instrument can contractually be settled in such a way that the investor would not recover substantially all of its initial recorded investment under paragraph 13(a). Whether that purchased asset is a financial asset or a nonfinancial asset (such as gold) is not relevant to the treatment of the excess purchase price.

It is noted that requiring the investor to make a cash payment to the issuer is also economically equivalent to reducing the principal on the note. The note described in the question above could have been structured to include terms requiring that the principal of the note be substantially reduced and the coupon reduced to zero if the interest rate for single-A rated debt increased to at least 10 percent at the end of 2 years. That alternative structure would clearly have required that the embedded derivative be accounted for separately, because that embedded derivative's existence would have resulted in the possibility that the hybrid instrument could contractually be settled in such a way that the investor would not recover substantially all of its initial recorded investment.

The above response has been authored by the FASB staff and represents the staff's views, although the Board has discussed the above response at a public meeting and chosen not to object to dissemination of that response. Official positions of the FASB are determined only after extensive due process and deliberation.